A pillar of the conventional wisdom of planning with charitable remainder trusts (CRTs) is that these very flexible split-interest trusts are subject to the private foundation excise tax on self-dealing transactions. But a recent IRS ruling has shaken that pillar and questioned the conventional wisdom.

Some (but not all) of the private foundation excise taxes apply to CRTs pursuant to Internal Revenue Code section 4947(a)(2), which provides that in the case of a trust which is not exempt under Code section 501(a) (i.e. a tax-exempt organization), not all of the unexpired interests which are devoted to one or more charitable purposes (i.e. a split-interest trust like a CRT) and which has amounts in trust for which a charitable deduction was allowed, Code section 4941 (excise tax on self-dealing) shall apply as if such trust were a private foundation.

In Private Letter Ruling 201713003, the grantor established a charitable remainder unitrust, but did not claim a charitable income tax deduction under section 170. The IRS ruled that because no charitable deduction was allowed, section 4947(a)(2) does not apply and the CRT is therefore not subject to any private foundation excise taxes, including self-dealing.

Many gift planners will find this surprising, since they may have erroneously remembered that section 4947(a)(2) applies to split interest trusts for which a charitable deduction was allowed or allowable, or maybe just accepted the conventional wisdom that CRTs are subject to the self-dealing rules. But this is one of those situations in which one shouldn’t rely on exegesis when one can consult the scripture, in this case the Internal Revenue Code. Here, a close reading of the statute supports the result of the ruling.

Speaking of exegesis, the ruling tells us that the basic purpose of section 4947 is to prevent split-interest trusts from being used to avoid the restrictions applicable to private foundations. The provision achieves its objective if the principal tax planning objective of the CRT to claim a charitable deduction for the present value of charitable remainder interest in the trust. But the second tax benefit of the CRT – frequently more valuable than the first – is the tax exemption of the trust, allowing the deferral of tax arising from the sale of appreciated assets. The grantor of the CRT in the ruling remained able to take advantage of this tax benefit, while freeing himself from the prohibition on self-dealing.

The ruling requires the taxpayer who might otherwise be subject to the excise tax on self-dealing transactions as a disqualified person with respect to the CRT maintain proof that no charitable deduction of any kind — income, estate or gift — has ever been taken (such as maintaining copies of tax returns for each year in which contributions were made to the trust).

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Case Study:
A practicing attorney who is the sole Trustor of a non-profit family trust loans his biological brother, also an attorney, 3 million dollars in the name of an LLC to purchase investment real estate. The Trustor brother never reveals this loan in his annual reports to the secretary of state, IRS, State of California tax office, not choosing to recognize his violation of self-dealing.
Could the initial purchase agreement for the property by the Trustor's brother be invalid to due the purchase being made with corrupted funds? Please advise...

Not sure what is meant by "non-profit family trust", but let's assume we're talking about a charitable remainder trust since that's what the ruling pertains to. If so, California CRTs are not required to report loans to the CA secretary of state. The CRT would not be required to report the loan as a self-dealing transaction to the IRS or CA Franchise Tax Board under this ruling if the trustor never claimed a charitable deduction (for either income tax or gift tax purposes) for contributions to the CRT. In any case, whether or not the loan to the brother was or was not self-dealing for tax purposes, I'm not sure why that would give the seller of the property the ability to invalidate the purchase agreement. @dwheelernewman

I agree with David on this. A brother is not, by that alone, a disqualified person for a private foundation (not an ascendant or descendant), so it might not be self-dealing. Even if self-dealing exists, it may result in tax penalties, but wouldn't give any special legal rights to the seller.

I am thinking if none of the private excise tax rules apply, the taxpayer could put 100% of a closely held business into the "Un-Charitable Remainder Trust" without requiring a sale. Also, the concerns about investments or commercial annuities being used as a spigot trust causing self-dealing problems would be eliminated. Does this sound right? If the first part is right, how about combining with a FMV sale agreement back to the heir with the receiving charity funded by an ILIT policy? If there was an ownership interest where you couldn't control the income coming out, wanted to keep the asset, but have spigot-like control on when the income was received and taxed, maybe this would be of interest? Thoughts?

Keep in mind that the prohibition on excess business holdings does not apply to most CRTs, since IRC 4947 which applies some private foundation restrictions to split-interest trusts, provides that IRC 4943, which prohibits excess business holdings, does not apply to a CRT if none of the income interest is payable to charity. So the taxpayer in your hypo could put 100% of a closely held business (so long as it isn't an S corporation) into the CRT and still claim the charitable deduction. However, if the plan is for the CRT to sell the business to the heir, a disqualified person for purposes of the self-dealing rules, the taxpayer would need to forego a charitable deduction as provided in the ruling. @dwheelernewman

My guess is that they were trying to avoid the self-dealing rules, so that the property contributed to the trust could have been sold to a disqualified person, which would otherwise be an act of self-dealing if Section 4947(a)(1) applies. If the remainder interest was only 10%, the income tax deduction lost may not have been that significant. And there may not have been any upfront gift if the settlor retained the power of revocation.

So, grantor sets up a CRT for himself, names a charity and retains the right to change it -- no gift to himself and no completed gift to charity for gift tax purposes, and grantor is willing to forego an income tax deduction for funding the CRT. What does avoiding the self-dealing rules allow the grantor to do with respect to the trust and the trust property that would otherwise have been prohibited? The grantor will still have to comply with the 664 regulations and avoid the grantor trust rules or the CRT will not be tax-exempt. What is to be gained by giving up an income tax deduction to avoid the application of the self-dealing rules?

So, grantor sets up a CRT for himself, names a charity and retains the right to change it -- no gift to himself and no completed gift to charity for gift tax purposes, and grantor is willing to forego an income tax deduction for funding the CRT. What does avoiding the self-dealing rules allow the grantor to do with respect to the trust and the trust property that would otherwise have been prohibited? The grantor will still have to comply with the 664 regulations and avoid the grantor trust rules or the CRT will not be tax-exempt. What is to be gained by giving up an income tax deduction to avoid the application of the self-dealing rules?